8/24/2006 @ 10:00AM

Five Funds For The Next Leg Up

Both the Equity Fund Outlook (EFO) Market Index and the Wilshire 5000 bottomed on June 13, rose, then fell back to a level a percent higher on July 17. There is a case for using the July 17 testing of the earlier low for an assumed starting point for the next rise.

For one, most secondary corrections take about two months to complete their nasty business; for two, most domestic diversified funds we track didn’t bottom out until the July low. This is especially true for small-cap funds.

Since it is still technically plausible that the July low was the end of a routine pullback in a rising market, let’s check out the few higher-rated funds for possible buys in the period ahead that have done better than the market since the July low.

PowerShares Dynamic Large-Cap Value is another exchange-traded fund (ETF) in the series that tracks the various Intellidex Indices developed by the American Stock Exchange. The object of the model is to provide a mix of stocks that will deliver an “enhanced” return over an unmanaged index, in this case undervalued large-cap stocks. In just over one year, PWV’s annualized return of 12.9% lines up favorably to the 6.2% return of the average large-cap value fund. As at PowerShares Dynamic Market (PWC) and Dynamic Mid-Cap (PWJ), there have been no capital gain distributions, but it does distribute income quarterly.

One in the series of funds that uses the Schwab Equity Rating system, Schwab Dividend Equity (SWDIX) has delivered a 2.5-point annualized premium over the average large-cap value fund over its 2.9 years and a 4.7-point premium over the market. Its ranking among 1,478 large-value funds over 12 months ending July is only 670, but it is interesting to investors seeking a low-risk addition to their portfolio. Assets total $567 million.

Polaris Global Value (PGVFX) is a consistent performer in the world stock scene. Over its 8-year life, its 8.6% annualized return was over twice that of the domestic market and 40% better than the Vanguard Total International Stock Market (VGTSX), the best proxy for all foreign markets. Over the last three years, its 19.8% annualized return was 2.5 points ahead of the average world stock fund and 8.9 points more than the domestic market. Its premium over the competition has lessened over the last year, owing to underweighting in the rebounding Japan market and energy. Manager Bernie Horn searches all markets for firms of any size he sees as undervalued when considering cash flow. When valuation targets are reached, he sells. Global Value is tax efficient. The new lower trading fees at Schwab argue for its consideration for any account that can handle market risk. Plan on holding it for at least six months to avoid a 1% redemption fee. Polaris is not available at Fidelity.

That Fairholme (FAIRX) made this cut is interesting since a third of the portfolio is on the sidelines waiting for the next “only the best” domestic or foreign opportunity that managers Bruce Berkowitz and Larry Pitkowsky are always looking for. They intend to hold on to two Canadian energy stocks that together are equally as large as their
Berkshire Hathaway
stake. Fairholme is the most efficient diversified fund in the EFO universe, despite its concentration in a handful of favorites (63% of assets is in the top ten holdings of its 34 issues). Its consistent record overcomes the usual reservations about excessive concentration, and it’s an obvious core holding for investors of all risk preferences. Assets total $2.6 billion.

ABN AMRO River Road Dynamic Equity Income (ARDEX) leads the all- and mid-cap offerings. This value vehicle is run by former Longleaf managers who prefer more diversification than practiced at that shop. Over its 13 months, its 14.2% annualized return was almost twice the return of the market and two-thirds again as much as the average mid-cap value fund, its closest peer group. A fifth of assets is in foreign issues; the largest sector is financial services. There is a real interest in income here, so the portfolio can hold real estate investment trusts and convertible preferred stocks as well as dividend-paying common stocks. Its yield is in the 2% area, but since there have been no been no capital gains distributions as yet, it’s acceptable for taxable accounts. The monthly distribution pattern could be a drawback for investors in taxable accounts who normally reinvest distributions, as figuring the cost basis of sold shares could be tedious. However, if one is seeking income, then Dynamic Equity Income is a good choice; just take the distributions in cash. An asset base of only $8.5 million is icing on the cake.